This report presents our observations and findings from visits we conducted in December 1999 to some of the commodity exchanges in India – see Appendix for details. We are very grateful to the officers and boards of the named exchanges for their support and assistance.

We have also included statements in respect of best practice for market surveillance and monitoring. This addresses both floor trading environments and electronic markets. Throughout the report our recommendations and suggestions are highlighted.

We do not seek to impose international practices upon Indian markets for the sake of it. Rather we have sought to take a much more pragmatic view and recommend improvements to procedures and organisation that we truly feel are achievable in the Indian market place. We look forward to exploring this further during the series of workshops in February 2000.

The principal areas for improvements in market surveillance and monitoring and where we suggest that changes be introduced are as follows:

• floor trading practices
• strengthening of the executive teams
• board structures
• prevention of price manipulation
• the creation of continuous liquid markets
• introduction of openly transparent markets

We have provided information on various techniques for operation of high quality market surveillance within the exchanges. This addresses floor trading, the financial strength of the membership and control of positions and relationships with the physical market. We have not delved in any detail into the clearing operations, as this is the subject of a separate consultancy report.

Although the practice of trading commodities is long established in India we feel that there is a need to update the manner in which the business is conducted for the benefit of everybody concerned. Localised exchanges exist throughout the country and it may be that in due course there is a move to concentrate certain commodities in regional exchanges or certainly a smaller number of exchanges. Exchanges want to have the ability to be able to distribute their products to a wider audience - both domestic and international. To achieve this, there has to be a move towards greater standardisation of procedure, improved distribution of product and price and an upgrading - to a much more professional level - of the manner in which business is traded, cleared and settled.

The conditions in Indian commodity exchanges described above have implications for the market surveillance function at the exchange level.

Because of inadequate infrastructure facilities and the markets being fragmented and disorganised, open-outcry trading is widely prevalent and preferred by market participants. Market surveillance under open outcry is recognised to be more difficult and prone to human errors and interventions. Market surveillance works better under the alternative online electronic trading systems.

However, exchanges with their small membership and transaction fees, face a lack of adequate funds required to implement online trading systems. In fact, most exchanges lack the financial resources even to professionalise and upgrade their management structure and skills, required to manage the surveillance function.

Players also show unwillingness to accept the margins and position limits, among the basic instruments needed to make the market monitoring effective.

Lack of funds is also cited by exchanges as the reason for them not owning any authorised delivery centres or controlled warehouses. Accordingly, the sanctity of a properly deliverable futures contract is not maintained and the contract becomes a tool for speculation only, not amenable to controlled market surveillance.

One of the principal reasons for the need for market surveillance and proper monitoring is to ensure the following:

• to ensure that business conducted on the exchange is performed in an orderly manner so as to afford proper protection to market users and investors
• the provision of arrangements and resources for the effective monitoring and enforcement of compliance with the exchange rules
• the provision of effective arrangements for the investigation into and resolution of possible complaints in respect of exchange business
• the promotion and maintenance of high standards of integrity and fair dealing in the transaction of exchange business

Orderly, well-regulated and managed markets inspire confidence and this, in turn, stimulates demand, liquidity and turnover. At all times however the surveillance and monitoring environment should operate in parallel to and be proportionate with the commercial interests of the exchange. It should assist rather that hinder the exchange’s capacity to innovate and its ability to create a liquid market offering commercial benefits to all its users, particularly customers.

Within India, each exchange also has the responsibility to co-operate where necessary with other domestic exchanges and other regulatory authorities.

The overall authority for regulation and compliance rests with the board of the exchange and is performed via its executive. There should be a strict division between the commercial and marketing function of the exchange on the one hand and its regulatory and compliance disciplines on the other. The regulatory division should ensure that the confidentiality of any sensitive or commercial information required for regulatory and monitoring purposes is preserved and segregated. This may also require additional physical security measures, which would limit physical access to the regulatory and compliance areas within the exchange offices.

• market floor operations
• electronic trading operations (where appropriate)
• market surveillance (monitoring market activity)
• member surveillance (to ascertain that members are acting in compliance with the exchange rules and that their procedures and systems promote a sound basis for their exchange activities)
• investigation (into any breaches of exchange rules and regulations)
• enforcement (where the exchange believes that there has been an identifiable breach of its rules, the matter might be referred to internal enforcement lawyers for consideration of formal disciplinary action as provided for within the exchange rules)

Exchanges for Physical (EFP’s) - Most exchanges find it useful to have a procedure whereby futures contracts can be registered on the exchange between trading counterparties under conditions whereby there is an existing physical market transaction between those counterparties. These are often referred to as "exchange for physicals" or "against actuals" transactions. This permits the counterparties to register futures contracts effectively without executing them on the floor of the exchange between themselves.

However the permission to do so should only be granted in such cases where documentary evidence, satisfactory to the exchange, is presented by the two counterparties to prove that a physical transaction does exist between the two. This is very useful to enable trading houses to close forward positions rather than make or take delivery on the futures exchanges.

Deliverable Supply - The exchange risk-monitoring group must seek to ensure that there is an orderly mechanism to the market. They should wish to avoid price manipulation and market squeezes. They must monitor the spot position daily. They maintain open interest figures for all members and record positions over a certain size (say 10 lots or 100 lots, depending on the market). They keep note of proprietary and customer positions separately. They have no jurisdiction over clients (this is the case with almost all exchanges).

They must look for concentration of positions and unusual sizes of positions. They should observe price differences and seasonal factors. They should compare between one delivery month and the next (asking – "Is this typically what happens with this member during a delivery period?").

They are really trying to be sure that they know who has what positions. They are trying, at all times, to assess the risk to the exchange.

To achieve this they would certainly employ a large position reporting system whereby members reported details of customer positions above a certain size. They might use also a computerised risk management system. This would combine details of positions held and of the financial strength of members, make comparisons and generate warnings. The clearing house, if separate, would conduct a similar exercise in parallel. Whereas both entities are seeking to achieve the same ends, they do have different responsibilities, because they may have different sets of members to whom they report.

The exchanges need to know who are the ultimate beneficial owners of positions. They want to discover what their intentions are as the delivery month approaches. They are monitoring any unusual positions or unusual trading activity. They will need to obtain answers by using a mixture of audit inspection, interview and discussion.

They want to find out who is buying and who is selling. They will want to see evidence of physical positions held in the cash market and will carry out member interviews and to some extent audits to satisfy themselves that they are being told the right information. Sometimes member firms will introduce their clients to the exchange who will vouch for the fact that underlying cash positions are being held.

The exchanges must avoid squeezes in supply. To achieve this they monitor the stock figures by using a reporting system that should be conducted at least weekly. Sometimes technical squeezes are caused on markets. Members may fail to obtain the necessary paperwork for the delivery administration - for example, failing to procure up-to-date grading certificates, without which material cannot be tendered (delivered).

The physical delivery of commodities under futures contracts made on the exchange is generally facilitated and supported by a network of approved warehouses. Exchange approved warehouses have a number of regulatory obligations under their contract with the exchange. Reporting of stocks and providing specifications of stocks held are a key responsibility of the warehouse operators and would be monitored by the exchange operations staff.

Exchanges should have their own warehouse inspection group, which contains sufficient resources to monitor warehouses activity and look after the registration and liaison relationship with them.

Exchanges will need to know what is happening on the cash market and to achieve this they have to have a good relationship with their members who are also trading on these markets.

All the commodity markets we visited in India operate currently under a system of open-outcry trading. This has always been the case and may continue for some time to come. We are aware however that there is a major debate in respect of the application of electronic trading. We provide some comments later in this report on that subject.

In all the exchanges that we visited there seemed to be a good degree of trading expertise and a similarity amongst the exchanges in the way that the trading was conducted, orders reached the trading members on the floor and systems of recording. We were not always satisfied however with the security and timeliness of the procedures. Nor did we feel that there was sufficient evidence of exchange control, owing mainly to the absence of exchange officials in the supervision of trading.

The procedures for trading should be recorded either in the rules of the exchange or in a separate procedural manual. This should be vigorously enforced by the exchange, which must have the ability to enforce business practice in line with their procedures. This will permit the exchange officials operating on the floor and at a higher level the Floor Committee and then the board of the exchange to have the power to investigate and to punish malpractice.

Traders should be licensed to take their position on the exchange floor. This should be only granted to such individuals who have the necessary experience and who have demonstrated they have the requisite expertise by passing examinations set by the exchange.

There should be strict procedures catering for the manner in which customer orders are handled, executed and reported back.

Prices pertaining in the market should be monitored at all times and recorded in a price reporting system. This will provide a computer-based record for order and control purposes. Only exchange staff on the floor of the exchange should operate it. These staff or their colleagues also on the floor of the exchange will also have the power and the responsibility to resolve disputes on the floor amongst the traders and to ensure that orderly markets exist.

Prices should be displayed locally within the market and also broadcast externally from the market and become available to all market users. This should be done preferably in real-time but certainly throughout the trading day at particular set intervals. It should not be the case that prices are only announced at the close of business.

There should be a strict procedure governing the manner in which closing prices (daily or at delivery month expiry) are defined. This should not be left to the traders but must be an exchange official’s decision.

There should be strict regulations in respect of trader conduct on the market floor. This will include all aspects of the mechanics of trading, the openness and fairness of trading with other members of the market and compliance with the timing and other regulations of the exchange. All these matters are effectively policed and enforced by the exchange officials on the exchange floor.

This section deals with the responsibilities of the exchange at various levels. We have examined the practices of the exchanges that we have visited and here we make recommendations as to the way in which we are satisfied and the degree to which we find that procedures should be improved in respect of organisational responsibilities.

Currently, most of the exchanges we visited seem to have a fairly standardised structure. Each Board has the majority or all of the members being elected members, and a few FMC-nominated members. Some attempts at making the boards more broad-based have been made, generally by following the system of pre-established Panels – representing different trade groups – which have the right to elect a pre-set number of members to the board. FMC-nominated directors do not have the right to vote on decisions, and the boards generally take decisions by a majority of the eligible and present members voting.

The basic fact is that in almost all exchanges, all of the directors are from the related commodity trade; only different segments of the trade such as the brokers, exporters or manufacturers/growers are grouped into panels for representation. The system is similar to the one followed by The London Metal Exchange.

1. Suggestion 1: Appointment of independent directors

In view of the critical role that the exchange board has to play in ensuring an orderly market - open price discovery and free of price manipulation - commodity and financial exchanges all over the world have been recognising the need for balancing the trade interests by appointing additional outside directors.

Independent directors bring with them a concern for public interest to be protected by the exchanges as public institutions. They also ensure that all board decisions are taken in broader interests of all the groups, not just in the interest of the trade groups or a few influential members.

 

2. Suggestion 2: Independent directors to have voting rights

In order that the independent directors really play the role expected of them, it is essential that they have the full voting rights along with the elected members. Mere observers or nominees on exchange boards do not serve much purpose, except that perhaps of asking questions or collecting some information or exerting some moral influence.

More importantly, it has been stated to us that the few currently FMC-nominated members are not in a position to attend all the meetings, effectively limiting even their observer or moral guardian status. Giving the voting rights to outside directors and the FMC-nominated members will ensure both their full interest in attending the meetings and their equal accountability for the board decisions.

3. Suggestion 3: Start with one third outside directors

The very suggestion of having non-trade persons as outside directors on their boards is an alien concept to the existing exchange boards. Giving these non-elected members voting rights is almost a revolutionary change for them. For these reasons, we recommend that the change be brought about somewhat slowly.

It should be noted that The Chicago Mercantile Exchange (CME) has almost a 50/50 ratio of elected/trade and non-elected outside directors. In India, the government has forced The Bombay Stock Exchange to adopt almost a 60/40 ratio of broker/outside directors (i.e. 60% nominated outside directors). While the public interest and the need to control the influence of powerful trade players points to such a wide representation to non-trade persons, the Indian commodity exchanges should not be subjected to such a shock-treatment right away. In the interest of an evolutionary but progressive move, we suggest that the FMC requires all exchanges to have one third of their board members drawn from non-trade persons.

4. Suggestion 4: Exchange boards to invite independent directors

While introducing the system of inducting outside directors on exchange boards, it is essential to avoid any divisiveness or confrontation situation. For this purpose, in line with the international practice at CME and other exchanges, the exchange boards should appoint the independent directors, not the FMC or any other body. A relationship of mutual confidence among board members is essential.

However, the FMC ought to lay down the qualifications required by independent persons in order to join the board. The FMC may even reserve the right to question the board's selected candidates or to disqualify any selected person for any perceived lack of required qualities. A system of pre-approved lists of director-candidates may also be considered to avoid any subsequent problem between the exchange boards and the FMC. But basically , we feel strongly that the system of independent directors will only work effectively and smoothly if candidates are selected and invited by the existing exchange boards.

5. Suggestion 5: FMC not to appoint directors

The FMC needs to be a strong and independent regulator. It has every right to ask for any information from or question the decisions of the exchange boards. That is why it is not necessary for the FMC officials to sit directly on the exchange boards. In fact, it is not desirable either for FMC officials to be part of the regular decision-making process at the exchange board level. They should be truly independent as regulators, supervising the boards, reviewing their decisions and even remitting them in question, but not be a party to the decision making.

The FMC should be advised in advance of all board meetings, and reserve the right to attend the deliberations if required in its judgement. But, the system of permanent FMC nominees on exchange boards ought to be terminated and replaced with the system of independent directors approved by the FMC (though finally selected by the exchanges themselves).

6. Suggestion 6: Outside directors' qualifications

It is suggested that the exchanges should be encouraged to draw up a list of qualified outside persons who could effectively contribute to both the decision making and the independence requirement, if inducted on exchange boards. The list ought to include professionals such as chartered accountants, lawyers and consultants associated with the commodity trade but not as traders or brokers. It could also include investor representatives or consumer activists. Some academics and economists with knowledge of the markets should also be considered.

7. Suggestion 7: Special approval for changes in price sensitive limits

Currently, the exchange boards are generally empowered to act during market emergencies or situations involving potential price manipulations. The boards’ powers are justified, but a general enabling by-law does not enable the FMC to be sure that the influential members of the board have not taken decisions only in the interest of affected members or the trading community. Coupled with the fact the current board membership is exclusively drawn from the trade, the independence of judgement in price sensitive decisions is not assured either.

In most situations, the FMC would come to learn of events after the fact. By definition therefore, any investigations by FMC or its corrective action will be too late. To ensure that the boards play an effective, independent and real-time role in situations of potential price manipulations, the FMC should require changes in exchange by-laws to provide for greater transparency in its decision making. Usually, decisions such as relaxation in daily/periodic price limits, or net open position volume limits or special margin requirements are all price sensitive decisions. The FMC should require that any such changes must be approved by say two-thirds or three-quarters of those board members present and by all or larger number of the independent directors present at the meeting.

The management of the exchange should be strictly independent of the board, the members and the end-users. This will ensure the integrity of the exchange and will prevent trading interests from influencing decision-making. It is rather like the role of the executive team within a listed company on the stock market. They are appointed to manage the company and are accountable to the board of directors and ultimately the shareholders. They can be hired and fired. Above all however they are impartial and are paid and given incentives fairly in respect of their management skills. This is exactly what is required in running an exchange business.

It is recommended that the key individuals in the executive team might perhaps be the following:

• the Chief Executive
• the Director responsible for Market Operations
• the Director responsible for Regulation and Compliance
• the Director responsible for Business Development & Marketing
• and finally, the Head of the Clearing House (where the exchange operates its own clearing division)

These are generic roles and there are also other functions to be undertaken - Accounts, Finance, Computer Operations, for example.

We believe that the selection of these individuals should be very carefully undertaken. Exchanges are relatively small teams of people and yet, by virtue of the amount of money that is at risk on the markets, they are responsible for maintaining an orderly business at all times.

The head of the team is the Chief Executive and the appointment of the person concerned should be carefully made with the person in question being well-educated, experienced and trained for the job and properly remunerated. They should be offered a contract with an appropriate duration and, working together with the board and its Chairman, the Chief Executive will carry out policy, make strategic plans and manage the business against that policy and plans. The other members of the executive group will be appointed by the Chief Executive and ratified by the board. This team will run the exchange.

Although this is not our specific brief, we thought we would for completeness, include some remarks in connection with regulation.

Within the Indian regulatory environment there are several effective stakeholders. These include the Forward Markets Commission, The Ministry of Consumer Affairs and the Reserve Bank of India.

The regulators in any financial centre have a responsibility to the government and to the general public to ensure that the operation of its markets is conducted in a proper manner and is monitored against agreed practices of fairness, integrity and openness. They also have a responsibility of interfacing with other jurisdictions in foreign markets.

In looking at any individual exchange in India the regulators must set the regulatory template under which each of the exchanges is permitted to operate and is expected to run its business. The regulators therefore must satisfy themselves that the exchange business is being conducted in a proper manner. They are likely to set guidelines for exchanges and will need to satisfy themselves at all times that exchanges are conducting their businesses in line with those guidelines. We do not think that the regulators have the right to manage the exchanges or to dictate commercial policy to the exchanges.

The regulator will also have the right to ask for various types of information from the exchange in respect of the dealing that is taking place. There is likely to be therefore a standard set of reports that the exchange and members will need to provide.

It may be that the exchange provides such reports on behalf of its members. The regulator must always be careful not to impose too restrictive or too onerous a set of responsibilities in respect of reporting on the exchanges. To comply with the regulatory reporting requirements takes time and costs money.

The regulators will seek to define procedures to:

1. Recognise and authorise commodity exchanges
2. Approve the rules and practices of the exchanges:

• To ensure a proper market with proper information
• Proper performance of transactions
• Proper recording of transactions
• Monitoring and enforcement of compliance with its rules
• Effective means of investigation into complaints
• High standards of fair dealing
• Sharing of information

1. Recognise their clearing houses
2. Define notification requirements – events and rule changes, for example.
3. Define reporting requirements – positions
4. Provide safeguards for investors

It is common for regulators to draw up their supervisory criteria and to invite exchanges to present a formal report annually to show how they intend to comply with the regulations over the coming year of operation. This is the Regulatory Plan.

Authorisation - Before any person can engage in investment activity they must be authorised. Carrying on investment activity without authorisation is a criminal offence.

In order to obtain authorisation (or a licence) the applicant has to establish, to the satisfaction of the regulator, that both it and its senior staff are ‘fit and proper persons’. The application of the "fit and proper person" test may exclude those who have previous criminal convictions, are bankrupt or have previously been publicly censured by a regulator. In addition, individuals such as directors and key employees may well be required to possess suitable professional qualifications and experience.

As well as assessing the matter of being "fit and proper" before issuing an authorisation, the regulators will also wish to ensure that the authorised person continues to be a "fit and proper person". For this reason they have standards against which they continue to monitor "fitness". These standards have various aspects including financial resources, capital adequacy and "Conduct of Business Rules".

Financial Resources - In establishing the minimum standards for the financial resources of institutions and monitoring the maintenance of these standards, the regulators are seeking to minimise any risk to investors and threat to the stability of the market from the failure of an institution because it becomes unable to meet its liabilities. Regulation is not designed to eliminate these risks entirely but to reduce them to an acceptably low level when viewed from the perspectives of both the investor and the market.

Capital Adequacy - The financial risk position of commodities firms is very different to, for example, banks. Their assets are in the form of highly liquid marketable goods capable of being rapidly realised if changing circumstances require. The major risk is not credit risk but position risk - the assets they hold will decrease in value before they can be resold. If for any reason the value of a firm’s assets begins to fall, then, because they are marketable they can be sold quickly and converted into less risky and volatile assets or the proceeds of sale held as cash. Less volatile assets will require less financial resources to cover the risk of loss. It follows that the capital requirements of a commodities firm are temporary in nature reflecting the fact that the firm can scale down its activities rapidly. The regulatory emphasis is therefore on maintaining liquidity rather than permanence.

Financial services regulators also adopt a risk-weighted approach to the regulation of financial resources. A firm’s financial resources requirement is typically made up of three elements:

The minimum or primary requirement - This is designed to act as a cushion against residual risks. If a firm is not generating any income it will still have expenses, such as salaries, rent and leasing charges to pay if it is to continue in business. The minimum requirement is the greater of a fixed sum or a percentage of the firm’s historic operating costs and expenses.

Position risk requirement - has the function of covering the risk of a firm having to realise its assets for less than it paid for them. Both the position risk requirement and the counterparty risk requirement must be calculated on a daily basis. Any loss made when a firm’s assets are sold must be capable of being met out of the firm’s financial resources. The amount of capital required to cover this risk varies depending on the perceived risk of the securities held. The amount of financial resources required is based on historical data which is used as an assessment of how far the assets’ value might fall before they can be sold.

Counterparty risk requirement - is the capital required to cover the risk that a counterparty will not meet its obligations as they fall due. For example, when a firm buys assets there will be a period of a few days between making the contract to buy and taking delivery of the assets and paying the purchase price. If the purchaser has already agreed to sell assets equivalent to those it has agreed to purchase then, if the seller fails to deliver, it will have to buy, in the open market, assets to meet its obligations to its own purchaser. If there has been an increase in the value of these assets, the firm will make a loss because it will have to pay more for the securities than it would otherwise have had to. The amount of capital required to cover the risk of a counterparty failing to settle transactions when due is a percentage of the value of the assets which have not been delivered when due. This percentage increases with the length of the delay. The longer the delay the more likely it is that the counterparty will never deliver.

The capital adequacy regime requires institutions to maintain sufficient financial resources to reduce the risk that they become insolvent and thereby cause loss to investors or other institutions. The regime does not guarantee they will not become insolvent but it does convey a certain degree of protection for private investors and depositors.

Client money protection or segregation of client funds - Most countries separate clients’ assets from those of the firm to whom they are entrusted, either by national law or market regulation. Before such laws, if an investor handed over money to a financial services firm to be invested or used to cover exchange transactions, and before any investments are purchased the investment firm becomes insolvent, the investor will rank, in most countries, as an ordinary unsecured creditor of the firm. The consequences of this are that the investor is only ever likely to recover, at best, a small proportion of the money originally handed over. The Client Money or Segregation regulations are intended to provide investors with additional protection in the event of a firm’s insolvency.

Conduct of Business Rules - In addition to the regulatory requirements relating to financial resources and treatment of client money by financial services firms, additional protection for investors was considered necessary. This was accomplished by requiring investment firms to comply with Conduct of Business Rules. The nature of investment products means that there are, usually, a large number of variable factors involved in assessing the suitability of any particular product for an investor. Most private investors do not possess the degree of skill and experience necessary to do this for themselves. In consequence they are highly dependent on professional advice and need to be assured that the advice they receive is both impartial and competent.

Conduct of Business Rules therefore seek to regulate the way in which authorised firms conduct their business with their customers. Failure by an authorised firm to comply with these rules can result in withdrawal of authorisation or other administrative or disciplinary sanctions. Private investors are given further protection through a statutory right of action against a financial services firm that has been in breach of the Conduct of Business Rules and thereby caused them loss. As professional traders and investors are generally more knowledgeable and have a stronger bargaining position when dealing with securities firms, the rules do not seek to provide the same degree of protection to them as to private investors.

The Conduct of Business Rules are wide ranging in their scope and because a breach of them can lead to civil liability or a claim for compensation, they are quite detailed in nature. The Rules regulate a number of different areas including advertising, customer agreements and the suitability of the products and services provided.

Advertising - Investors are perceived to be particularly susceptible to the persuasive powers of advertisements. The Conduct of Business Rules therefore seek to control this influence by heavily regulating investment advertisements. When preparing an investment advertisement a firm must be fair and not misleading. Additionally, an investment advertisement must contain a risk warning relating to the risks associated with the investments being advertised. Other specific requirements will also have to be complied with in appropriate circumstances. In addition to regulating investment advertisements, the unsolicited oral promotion of services or products, commonly known as ‘cold calling’, is also heavily regulated.

Customer agreements - When an investor enters into an arrangement with an investment firm for investment advice, the Conduct of Business Rules require that the investment firm enter into a written agreement, which must contain specified information. This agreement must include, for example, a statement of the services to be provided by the investment firm and a statement of the basis on which the firm is to charge for its services.

Suitability - Securities firms are required to ensure that they take reasonable steps that the advice that they give to a private customer or any transaction that they carry out on a discretionary basis is suitable for the customer concerned. Associated with this requirement are rules which require that an investment firm must inform itself in sufficient depth about any investor’s financial situation to ensure that any recommendations it makes or transactions it effects on a discretionary basis are suitable.

Exchanges and their clearing corporations should have explicit rules as to the approval of and acceptance into membership of applicant companies. The most obvious requirement for this will be the financial integrity of the company concerned. Nevertheless there are many other attributes that need to be investigated by the exchange executives when companies are seeking to become members of a market.

Besides the financial criteria it will also be necessary for the exchange to satisfy themselves as to the expertise of the managers and the owners of the business and their rationale in wishing to use the exchange products. Why are they using these products? What are their intentions and how expert are they and what is their previous track record of activity in commodity markets? It should not be a question of purely tradition it must be evidence now of the company being able to discharge properly its responsibilities to all other members of the market if it becomes a member.

Beyond the executive and board of the applicant member the exchange will also need to satisfy itself that the trading individuals and the systems employed within the company are of a suitable standard and experience. Declaring that traders have to pass examinations before they are permitted to trade can partly ensure this. For example on the EUREX market there is an extremely comprehensive trading examination, which examines the understanding of individual traders, and those traders are not permitted to commence using the electronic trading system until they have passed.

This is the type of approach that we would recommend for the Indian markets too - be they open-outcry or electronic markets. All traders should take their responsibilities very seriously. Clerks on trading floors similarly should be registered and should have passed some form of examination to show that they understand the market, its procedures and rules and that they are being bound by those rules as responsible members of their firms. The firms themselves can be fined if the registered trading members or their clerks do not follow the exchange rules properly.

The exchanges must ensure that applicants for membership meet certain minimum standards. These may differ slightly between clearing and non-clearing applicants, but the fundamentals are the same. In giving general guidance on this matter, we recommend as follows:

1. Only "fit and proper" applicants may be accepted.
2. Applicants must demonstrate financial and business standing suitable for membership.
3. Applicants should be authorised by the appropriate regulator, where relevant.
4. The company should have "fit and proper" staff, suitably qualified and experienced. It should possess moreover adequate procedures and controls with respect to its intended business on the market.

The most effective way of preventing price manipulation in the markets is to ensure the creation of liquid, continuous and transparent markets - which ensure a fair and free price discovery process.

The creation of liquid markets for commodity futures requires three fundamentals:

• successful commodity contracts with liquid underlying cash markets
• a large number of market participants both as hedgers and speculators
• an efficient and transparent trading process

Indian commodity markets suffer from basic illiquidity in underlying cash markets, due to restrictions and constraints on movement of goods, small and geographically fragmented markets for each commodity, and absence of nation-wide warehousing facilities. Correct government policies are needed to encourage a nation-wide market for all commodities. Some conditions are now being satisfied, such as a uniform sales tax rate throughout all states. However, for futures markets, it is not necessary to confine them to the producing regions. What is important is the presence of the speculative class, which provides the liquidity. Hence, the number of participants in the futures markets is more important than even the physical supply constraints.

1. Suggestion 1: Exchanges should decide their contracts. Decisions on which commodity contract to trade should be left to the exchange, not taken by the FMC. The Exchange authorities will have an interest in coming up with the contract with the best liquidity potential. Competition among exchanges will be healthy as they seek to attract the greatest number of market participants as exchange members or non-members.
2. Suggestion 2: Restrict multiple contracts. Liquidity is hampered by the existence of multiple contracts in the same commodity both among and within the exchanges. In cases of the same commodity contract being traded on many exchanges and because of the fundamentally low volumes in underlying cash markets for each commodity, the FMC should aim at achieving liquidity by encouraging - but not forcing each exchange - to allow trading in as few commodities as possible, at least until a National Commodities Exchange emerges. More importantly, there is no justification for having two contracts in the same commodity traded on the same exchange - one domestic and one international.

The existence of two such contracts in the same commodity in the same exchange is the cause of the fragmentation of liquidity in the Pepper contract at Kochi and a non-starter Castor Oil contract at BOOEL. There should be only one contract, Pepper or Castor Oil, traded on these exchanges, with distinction between domestic and international contract abolished. The solution to perceived problems in attracting "foreign" market participants lies in the FMC ensuring with the Government and the RBI that they ensure that international players obtain the required financial settlement and delivery facilities. That is all they need; they do not need a special "international" contract. Dollar denominated contracts are a failure and ought to be recognised as such. They fragment market liquidity and in fact can become a source of price manipulation as two separate trading rules, limits and margins apply to the two contracts.

In fact, it has been observed that trading at Kochi moves to the international contract only when the domestic contract price limits are reached. Making the two contracts follow the same price and margin limits would be correct but it would tantamount to having one contract traded anyway. There has to be only one contract per commodity for both domestic and international players, with separate settlement and delivery facilities for the international players, but no separately traded contracts.

3. Suggestion 3: Pragmatism in approval of exchanges. The FMC policy of approving futures contracts for exchanges near the regions producing the underlying commodities should be discontinued. Instead, as suggested by Prof. Albrecht, FMC approval should be given to exchanges with the acceptable infrastructure and a potentially large trading community/membership, irrespective of the exchange location in relation to the commodity-producing centre.

For example, it is proven that Ahmedabad has a large enough speculative, trading and broker class that can generate significant liquidity provided their infrastructure and market surveillance systems are enhanced. Similarly, The East India Jute & Hessian Exchange in Calcutta has a reasonably good infrastructure and a large trading community membership.

The creation of continuous markets requires all measures at the Exchange level and at the FMC level that ensure that there are no disruptions in the functioning of the trading or clearing arrangements. India’s stock market experience has confirmed this lesson time and again. Expectations of disruptions are used by market players to manipulate the prices. This can lead to a kind of "unnatural speculation". Healthy speculation in continuous markets is essential to ensure liquid, deep markets where manipulation becomes difficult.

1. Suggestion 1: Certainty of approval of delivery months. The FMC should approve once and for all, for each commodity, how many contracts (meaning maturity dates) will remain available for trading at any given time, as part of the contract specifications.

Market participants must know at all times whether trading will be continuously done in two or three or more contracts or maturity dates. They must be able to count on the next maturity contract becoming available immediately after the previous maturity contract ends. Any uncertainty about the opening of trading in the next contract maturity upsets the hedging utility for the hedgers and all speculative calculations, as a result increasing risks for both.

It is vitally important for the FMC to ensure continuous markets to let the trading go on uninterrupted, and abandon its existing practice of requiring each exchange to request specifically its approval before opening trading in the next maturity contract. In fact, of late, such renewals have also been held up for significant periods of time, thereby resulting in virtual closure of the markets.

Whatever regulatory action is required to be taken against an exchange should be taken by other means than by adopting disruptive measures such as stopping trading in a continuously traded commodity. It is in fact not unthinkable for the exchange to cause FMC approval to be withheld if it suits the big and influential market participants. The guiding principle for the FMC ought to be the contrary: to punish the exchanges that do not ensure continuous trading or resort to frequent closures.

It is also desirable for the FMC to use fines as a punishment measure, rather than withholding the approval for trading of the next maturity contract. Since the Indian exchanges and the trading community have meagre resources, the financial penalties and fines will hurt more and be therefore more effective in getting the exchanges to toe the regulators’ line.

2. Suggestion 2: Trading to remain open. For the same reasons, the FMC should monitor the exchanges to ensure that trading remains open in all contract months at all times as stipulated and impose a reporting requirement on any disruptions or closures, the details thereof, and the reasons thereof.

The board should be held responsible for the justification and ought to be warned if it appears that the disruption was not warranted. Again, this measure is essential not only to ensure continuous markets but also to prevent the influential members from using the trading halts and closures as a means of price manipulation.

Current FMC Policy on Price Movements - The FMC currently follows a set of policies that are summarised below:

1. In all but one of the eleven commodities, there are also absolute amount price limits for daily or weekly price fluctuations (two out of ten commodities on weekly limits).
2. These limits are set as absolute amounts per basic unit of trading on the floor (per quintal or kg or mt or 100 bags, etc).
3. As it appears, the absolute daily or weekly price limits apply to all traded contracts in a given commodity, until a request is made by the exchange and approved by the FMC.
4. In one case - Castorseed, however, the limit has been set as a percentage of the benchmark price.

Tick Sizes for Price Quotations for Each Commodity - Finally, the tick sizes are specified and approved for floor price quotes, which apply to all traded contracts in a given commodity. They remain in force until a change is requested by the exchange and approved by the FMC. They are rarely changed in practice. (Suggestion - tick size to bear relation to current market price level and in percentages and not absolute fixed amounts).

Price Limits Part of the By-laws - In all cases, the price limits are part of the Contract Specifications included in the By-laws of each exchange and are changed by correspondence between the exchange and the FMC. Each change in the limit amount or basis requires the prior approval of the FMC.

Recommendations on Price Limits - The key question to be answered by the market practitioners is: "Do absolute price limits achieve the purpose of controlling possible price manipulations in the futures markets?"

In our judgement, absolute price limits on traded contract prices create two problems:

1. Trading halts on official markets may move trading to unofficial markets or even lead to underground official markets through unreported trades at prices outside the limits.
2. Futures prices may get out of line with cash market prices, which may be undergoing major price trend-changes.

In other words, all futures price moves outside a previously determined absolute limit do not necessarily suggest the existence of price manipulation.

The objective of price manipulation can best be achieved by following the basis or price differentials between the cash and futures prices, to be able to detect unusual compression or enlargement of the differential, in relation to the deliverable supply. Forcing the market price to remain in a defined price band, when there is no change in the basis, may actually encourage price manipulation as the operators know in advance the absolute price limits and so the likely basis changes as they follow the cash market prices.

1. Suggestion 1: Monitor changes in basis. The FMC will have to track the basis changes and investigate unusual moves in basis as the possible indication of price manipulation. With this ability, the FMC will be in a position to refrain from prescribing or approving the absolute ceiling and floor prices. If the exchanges want, they may continue such limits, probably in unusual circumstances. But the exchange boards must be held accountable for unexplained changes in the basis in relation to the deliverable supply and prices in the underlying cash markets.
2. Suggestion 2: Remove artificial price limits. One of the FMC’s major objectives is to discourage the unofficial markets. By freeing up the official markets from somewhat artificial absolute price limits, it will encourage the official markets to capture all trades and increase liquidity by increasing the confidence in the official markets (that they will not be closed or that its price discovery function will not be tampered with). Current system of prescribing ceiling and floor prices is thus self-defeating for the purpose of making the official markets more attractive.
3. Suggestion 3: Change basis for setting limits. It is recognised that there may be need for some benchmark upside and downside limits in case of Indian markets. At least the benchmarks set on the basis of the first day’s freely determined prices do have some relation to the cash market prices. However, the use of absolute limits based on the first day’s price discovery for the entire remaining life of the contract does ignore the subsequent market developments.

 

The Ahmedabad system for the castorseed contract is to set the price limits as a percentage of the benchmark price is better, but it still fixes the limits for the entire life of the contract. Therefore, as long as the limits are not completely to be abandoned and set by the exchanges themselves, we suggest that the price limits be set daily as a percentage of the previous day’s closing prices, as has been permitted by the FMC in the case of BOOEL’s Castor Oil contract. As a first step, the FMC may consider imposing the limits on all commodities as moving limits based on the previous day’s closing prices.

4. Suggestion 4: Limits to represent current price levels. For the same reasons as above, the daily limits for price movements on the floor should also be set as a percentage of the current market prices - using the previous day’s closing prices as the current price. Specifying them as fixed amounts ignores the current price levels and may not lead to systematic price moves. The purpose of the -specification is only to assure orderly movement of the traded prices on the floor, not to set limits on the absolute movements over the entire life of the contract or even ad infinitum until the exchange requests a change.
5. Suggestion 5: Exchange boards to decide the limits. Ultimately, the objective ought to be for the FMC to move away from specifying any price limits and leaving that power to the exchange board committees (clearing committee or market operations or floor committee). What the FMC must approve is the basis of determination of the price limits for orderly movements, not absolute limits or overnight or contract-life movement limits. To prevent price manipulation it must track the basis and ask the boards to explain any major change.

Suggestion 6: Ensure accurate cash market prices. As the basis becomes an instrument of watching for price manipulation, the cash market price quotations used to calculate basis become very important. Cash prices are also important as the basis of determination of the due date rates or settlement prices. Accordingly, the FMC must review and approve the way in which the cash market prices are collected. No general method can be prescribed that will be valid for all commodities. Hence, the FMC must study the cash markets underlying each of the futures contracts and issue appropriate guidelines or accept the exchange board’s recommendations.

Finally, the exchange by-laws ought to be amended to include the basis of determination of cash prices and futures price limits, avoiding the specific amounts of limits so that the need for lengthy correspondence and review of each specific change is obviated. More importantly, it will both give flexibility to and hold accountable the exchange boards.

The third essential precondition to avoid price manipulation from taking place is to ensure that each exchange sets up transparent procedures for market surveillance, trading, clearing, settlement and delivery. Lack of transparency can often be used by the exchange regulators to bend rules, to shield influential players or to cover any cases of price manipulations.

1. Suggestion 1: Exchanges to submit operating manuals. Each exchange must be asked to submit not only the By-laws but also the Operating Manuals of rules for the members to follow, covering trading, clearing, settlement and delivery, besides general reporting and compliance. Most of the existing by-laws are far too general and do not incorporate detailed and transparent procedures required by the exchange or the clearing houses. The FMC should make it a practice to question any of the operating procedures if it is not clear.

It should also authorise frequent inspections to monitor compliance with trading, clearing, settlement and delivery rules. Detailed manuals will also require the exchanges to give sufficient attention to building up a regular management staff (as opposed to only a minimum operating staff as at present).

2. Suggestion 2: Futures contracts only. Abolish forward contracts (TSDC& NTSDC) and have only exchange traded futures contracts. In the context of already thin cash markets in most commodities, existence of both forwards and futures hurts liquidity, stretches deliverable supply, and eventually leads to futures being used only for non-delivery (speculative) transactions. So that, in reality and contrary to the GOI and FMC intentions, the TSDC and NTSDC forward contracts are the real hedging contracts, and the futures contracts called "Hedge Contracts" are reduced to being merely speculative.

The fact is that the thin commodity supply, trading interest and volumes require that only one futures contract, deliverable as the current forward contract, be traded on the exchange. All market players, whether they want future delivery or not, should be brought to the exchange traded contract as a common vehicle to hedge or to speculate. We have checked the attractiveness of this suggestion with some Calcutta Jute Exchange trading members. More exchange feedback can be obtained at the time of the proposed workshops.

However, this is one of the most important recommendations we have to make, in the interest of creating more liquid and transparent markets, less amenable to price manipulation because of the one standard trading, price discovery and delivery mechanism.

It will also empower the exchanges to control the delivery mechanism and ensure that the delivery process is not used to manipulate the price situation. One cash market and one futures contracts with standard delivery terms are all that is needed for each commodity. The suggestion will also make it more meaningful for the FMC to track both price trends and the deliverable supply position; merely asking for these numbers from the exchanges is not a guarantee of protection against potential market manipulation.

Currently, in the case of Jute for example, real hedgers and jute mills go to delivery contracts, while speculators trade the futures contracts. With only one deliverable futures contract, the hedgers will also move to the official markets - an important objective that the FMC has been trying to achieve.

3. Suggestion 3: Combine reporting requirements. In the meantime, the FMC should call for combined volume of TSDC/NTSDC and hedge contracts for each commodity to be reported to them. These figures are needed for a complete picture of the commodity futures trading and to arrive at a judgement on whether the price discovery process is transparent enough or whether there has been any price manipulation.

Exchanges must ensure that all member firms and commodity storage facilities comply with the exchange rules and guidelines. The methods of achieving this are outlined in this section.

• verifying the financial strength and compliance of member firms
• margining procedures and margin levels
• segregation of house and client accounts
• large position reporting
• modelling of "What If?" scenarios
• triggering alerts
• monitoring of member capital against market exposure
• analysing trading activity patterns

Various financial reporting triggers can give the exchange an indication of a firm’s market exposure.

• any margin call in excess of net capital
• any events which reduce capital by more than an agreed percentage
• decreases in capital since the last reporting period by more than an agreed percentage

In any such event, the exchange must discuss the matter with the member concerned.

It is possible for exchanges to monitor the patterns of members’ trading activity over periods of time. Using computer systems, the risk management team may build a profile of a member firm’s typical trading behaviour and the orders to which they refer. By analysing the patterns, any resulting anomaly can be identified and investigated.

This technique is employed at the Chicago Board of Trade (CBOT). Their SMART system for risk management has been developed at substantial cost. It helps the exchange identify areas for further investigation.

It is able to detect patterns and can flag possible breaches of rules in:

• pre-empting customer orders
• pre-arranged trading
• non-competitive trading
• changes in patterns
• bypassing of orders
• proprietary trading activity taking place to the detriment of customers

Breaches should lead to disciplinary measures and/or the restitution of the financial position in favour of the "victim".

In the case of the CBOT, the exchange has 34 staff in the Financial Surveillance Department alone. They monitor the activity of some 3,500 floor members daily. This can be understood considering that the daily underlying contract values are measured in billions of US Dollars.

We should like to express our thanks to the boards and executives of the following exchanges who kindly received us and allowed us to interview them in respect of the operational procedures of their exchanges. We are most grateful to them for their co-operation and openness.